Price and Underlying Markets

In this lesson:
  • The linear correlation between the spread price and the underlying market price 
  • The built-in risk/reward structure of the floor and ceiling
  • The edge: the reason the spread price is higher than the underlying indicative price

Here’s a simple way to think about Nadex spreads. Instead of trying to trade the entire bottom to top range of a trend, you take one segment of that trend and focus on that. Within that range, your Nadex spread gains and loses value in correlation with the underlying market's gains and losses. But at the top and bottom of the range, the price stops at a maximum or minimum and doesn't move further. 

A Nadex spread confines the price action within the floor to ceiling range. When the underlying price goes outside that range, the spread price will stop moving and rest at the floor or ceiling. If the market comes back into that range, the spread will move with it again.

This gives you a way to trade up or down movement within a price range, without the need for stops. You get movement similar to what you get trading forex, stocks, or futures, but with a limit to how much you can lose and a limit to how much you can gain, giving you a natural profit target.

The floor and ceiling

Spreads offer you limited risk by having a minimum value they can’t go below. This means that if the underlying market price moves below that value, the floor price, the spread’s value won’t drop further. The spread’s correlation with the market simply disengages and the spread value stops moving.

It also means that the spread’s value can only go as high as the ceiling. If you are a buyer and the market goes up, your spread automatically gives you a profit target, because it won’t be able to increase in value beyond that point. Most traders find this makes planning a trade and sticking to that trading plan easier.

But if the market is continuing to go up, you may want to continue to trade that movement. Because of the short-term nature of Nadex spreads, you can easily buy another spread at a higher price and do it again.

Why is the spread price higher than the underlying market price?

In exchange for the limited risk advantage you get with the spread, your spread price is adjusted to include the value of the protection. The spread price also reflects the profit potential of the spread, the amount it can continue to go up or down to bring more profits your way.

If the futures price is inside the spread’s range, then the spread will have some amount of what’s called “intrinsic value.” Intrinsic value is also factored into the initial cost. You’ll pay more for a spread that has a higher probability of expiring with a profit.

Because you are paying not just for the futures price, but also the combination of limited risk with profit potential that the spread gives you, you enter at a small price disadvantage. You give up an edge in exchange for the protection and profit potential you get at such a low cost. 

As a result, the market will have to move a small distance in your direction before you’ll break even and start to profit. This is what makes spread trading a manageable but challenging way to trade.

Close correlation with the underlying market

When the underlying market whether it’s the Aussie Dollar/Japanese Yen exchange rate, crude oil futures, or the Nasdaq) moves one tick, the spread price moves one tick as well.

In other words, within the spread’s range, the price moves the same way the underlying market moves. You won’t see the sudden volatility you might see with options. Neither will you see the price failing to move when the market is ticking up or down slowly. It’s a close correlation until you approach the floor or ceiling. This makes Nadex spreads a less expensive way to trade the underlying markets from which they are derived.

 

At this point you should understand:
  • How the spread price moves in close linear correlation with the underlying within the range
  • What the floor and ceiling of a spread are and how they limit risk and give you a profit target
  • How the spread is priced relative to the price of the underlying indicative market

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